Let’s Make a (Fiscal) Deal (1Q17)
Donald Trump’s presidency has brought a few surprises for investors in his first 100 days in office.
Politics aside, the quarter just past was the calmest for the Standard & Poor’s 500 Index in decades as measured by volatility and daily market movement. Who saw that coming under an iconoclastic new leader on a mission of drastic change? Declines in the dollar and the yield on the benchmark 10-year Treasury note also were noteworthy, since the pundits assumed both would keep rising under a pro-growth, America-first administration.
The most striking revelation for over-amped markets, however, was that even a renowned dealmaker’s plans can get thrown off schedule or blocked when Congress is involved.
The S&P 500 rose 13 percent between Election Day and March 1st on optimism over the ambitious Trump trifecta of pro-growth plans – tax reform, deregulation and trillion-dollar infrastructure spending. As Wall Street often does, it had a knee-jerk reaction and pushed stocks higher by assuming rosy scenarios for approval and enactment. They might better have heeded some of Trump’s core strategies from his “The Art of the Deal,” such as “Protect the downside” or “Most deals fall out, no matter how promising they seem at first.”
This is not to say that the president will fail to secure congressional approval for his fiscal initiatives – he may well in the end. But it is clear from these early months that this deal, or these deals, will not go down easily. It may be 2018 before any real stimulus kicks in. We will watch closely to see how the plans fare in Washington. Sentiments on the economy also are running high without much strong fundamental data follow-through that we would like to see before altering client portfolios. Growth remains uninspiring.
Nevertheless, the risk of recession that lurked a year ago has eased, the job market has strengthened and inflation has finally reached the Federal Reserve’s 2 percent goal. With companies in the process of reporting a third straight quarter of year-over-year earnings growth, the economy appears on solid footing. We feel the Fed’s plan to gradually remove the “punch” of accommodative monetary policy will not necessarily wreck the market’s party – especially if the global economy continues to improve and Trump and Congress can deliver some fiscal fizz.
Read on for our more detailed thoughts on this quarter’s market-related topics of interest:
1. Trump’s first 100 days have not brought clarity on which policies will become reality.
We have Franklin Roosevelt to blame for our national obsession with using the hundred-day milestone as a litmus test of a president’s success or failure.
FDR, of course, took office during an unprecedented national economic crisis in 1933 and focused on his first 100 days to underscore the urgency of efforts to lift the nation out of the Great Depression. The result was a whirlwind of accomplishments that included launching his New Deal reforms and shepherding 15 major bills through Congress.
Almost every president since has had a difficult time of it in the first 100 days, from dysfunction with a new team to struggling to advance policy goals to dealing with recalcitrant lawmakers. That is certainly the case with the current administration, whose turbulence has been magnified because of the president’s bluntness and his status as a political neophyte.
Getting a firm handle on his policies and their likely fate will take more time than this (97 days, as we publish) for a couple of major reasons.
Delays and position changes
Even with the White House and both chambers of Congress under the same party’s control for the first time in six years, the Trump plan to energize the economy with a massive fiscal stimulus package remains stuck at the starting line.
The biggest roadblock is the fractious House, where power is divided among Speaker Paul Ryan, the ultra-conservative Freedom Caucus and Republican moderates. That gridlock defeated Trump’s effort to repeal and replace the Affordable Care Act, consequently holding up his promised tax overhaul. Because of the time needed to pass a tax package and the lag before it has any economic impact, any pickup in growth from fiscal stimulus is now unlikely to be felt before next year.
The defeat of the health care bill hardly dooms the president’s agenda but it does complicate and delay it. We are now watching to see if the administration settles for a more modest package of tax cuts rather than sweeping tax reform. First the Republicans must pass a budget that overcomes initial resistance to the White House’s proposed deep cuts in non-defense spending.
In the meantime, the new president has issued more than two dozen executive orders, including his first steps on deregulation – another top priority aimed at boosting corporate growth. His envisioned $1 trillion infrastructure spending plan has yet to even be drawn up.
Compounding the uncertainty for investors is the president’s willingness to reverse his policy stance on significant issues as he gains his footing in the new job. His changed views just in the past month include those on Fed Chair Janet Yellen (she might get to keep the job now), China (no longer a currency manipulator), NATO (not obsolete) and the U.S. Export-Import Bank (“a very good thing”).
President Trump told reporters this month that “I like to think of myself as a very flexible person.” We think investors, too, need to remain flexible in terms of not making premature assumptions about the president’s evolving policies and which way they might move markets. It is worth noting that even the most effective presidents get only a modest amount of what they campaigned on through Congress.
The uncertainty and delays halted the “Trump trade,” temporarily at least, about six weeks into his term. The stock market wavered in early March after the S&P 500 peaked at 2400 and has given back a small part of those gains.
Gap between expectations and reality
Now the question for markets is whether similar enthusiasm expressed in national business and consumer surveys will lead to increased business investment and economic growth or whether it is based on hope alone.
Consumer confidence and small business optimism both reached their highest levels in over a decade in the first quarter on expectations for pro-growth policies. Yet “hard” economic data do not reflect this rise in sentiment. GDP has yet to break out of its slow-growth mode, industrial production is flat and retail sales fell in February and March, the worst two-month stretch in two years.
Those were most likely just seasonal hiccups rather than signs of real weakness. Yet they do not portray an economy surging upward, like the so-called “soft” data have been. The rise in sentiment is unlikely to last without progress soon on the president’s big-ticket fiscal items.
We still think the chances are good for a beneficial fiscal expansion of some kind, in view of this administration’s pro-growth priorities. But given the market’s already-high valuation and the continued uncertainty about the timing or scope of any stimulus, we recommend clients remain at their long-term asset allocation targets.
2. Optimism about election outcomes and rising inflation in Europe has helped European and international stocks, although the continent still faces significant challenges.
Pro-growth hopes for the Trump era have not been the sole source of market positivity, especially internationally.
Even against a backdrop of simmering geopolitical concerns – notably involving Syria, North Korea, European elections and Russia – the iShares MSCI All-Country World ex-US ETF has outpaced the U.S. market by 2 percentage points since the beginning of the year. We view it in part as overdue outperformance, a reversion to the mean, given that international shares have lagged the S&P 500 every year since 2012 – a disparity that likely cannot last.
Europe’s resurgence has been instrumental: After being held back last year by Brexit and worries about the eurozone’s future, European shares had their best quarter since 2015. The pan-European STOXX 600 gained 5.5 percent from January through March.
International investments in dollar terms have benefited from a weaker-than-expected greenback in 2017. Beyond that, these markets’ outperformance is linked to optimism (that word again) about economic improvement. Current risks notwithstanding, the global economy appears healthier than it has in several years.
The brightened prospects stem from:
- Reduced chances of an anti-euro candidate coming to power. Geert Wilders lost to Dutch Prime Minister Mark Rutte, Marine Le Pen was seen as unlikely to win the French presidential election and Italy’s election was put off until late 2017 or 2018.
- Weak inflation finally strengthening in Europe, where the rate in the eurozone touched 2 percent for the first time since 2013 after a long period of disinflation/deflation.
- Consistently more positive economic signs in Europe: Growing business confidence, improved retail sales, growth picking up in Germany and France, strong earnings, European PMI (purchasing managers’ index) at a six-year high and a series of merger and acquisitions deals in the region.
- Diminishing concerns about a hard landing for China’s economy.
- Several emerging economies (Brazil, Nigeria, Russia) coming out of recession.
Substantial challenges remain for Europe. Growth is still being held back by structural problems – including bad loans that have hamstrung Europe’s banks and overregulation – as well as political uncertainty. An upset victory by Le Pen in France’s May 7th presidential runoff would revive fears about the collapse of the eurozone. Important elections in the United Kingdom, Germany and Italy soon follow.
Nonetheless, the significance of the continent’s accelerating recovery was underscored by European Central Bank President Mario Draghi in essentially declaring victory over the threat of deflation, saying there no longer is any urgency for additional stimulative measures.
We view it as beneficial for European stocks, and our clients’ international investments, that the ECB remains committed to keeping up its 60-million-euro ($65 million) monthly bond purchases through at least December. Despite their disappointing performance in recent years and Europe’s structural problems, this easy-money flow and the more attractive stock valuations to be found abroad are good reasons to maintain a full weighting to international stocks.
3. The outlook for bonds remains stable; they respond more to economic fundamentals than short-term rate changes.
Based on the surface numbers, the bond market appears to have changed little in the early months of 2017. A closer look, however, reveals a couple of important takeaways.
The yield on the 10-year U.S. Treasury note ended the first quarter close to where it began, dipping to 2.39 percent from 2.45 percent. That was one of the smallest quarterly movements in recent years. Bond funds enjoyed welcome but still modest quarterly gains after a volatile fourth quarter of 2016.
Yet the 10-year yield’s pullback after reaching a high-water mark of 2.63 percent in mid-March spoke volumes. For the yield to decline even after a Fed rate increase testifies to the bond market’s skepticism about expectations for higher growth and inflation.
Going into the year, there was speculation among many (although not us or our recommended bond managers) that the yield would continue to rise sharply, putting pressure on bond investments and carrying repercussions for other markets. Given the holdup in President Trump’s fiscal stimulus agenda, that scenario now seems far less likely.
The continuing drop in the yield in the first few weeks of April only strengthens our conviction that the long end of the bond market ultimately reacts to growth and inflation, not to the Fed or short-term market noise. Neither category now appears headed meaningfully higher in 2017 based on the current political and economic outlook.
Notably, too, a flattening yield curve underscored that short-term bonds are generally not the best place to be during a rate-hike cycle.
Yields on intermediate- and long-term bonds scarcely budged during the quarter. Short-term yields, the most sensitive to Fed policy, fell. That flattening curve – a narrowing difference in yield between short- and long-term bonds – expressed the bond market’s pessimism that the economy will heat up any time soon.
Our bond managers have been positioned mostly in intermediate bonds, which has enabled them to better capture gains in 2017. We believe reducing duration at this juncture would be counterproductive, since the Fed controls the short end of the curve and may raise rates again as soon as June.
In terms of allocations, we see nothing to alter the view we expressed in our fourth-quarter commentary: Without meaningful increases in GDP or inflation, we believe clients should retain their long-term target position in bonds based on the asset class’s lower risk and ability to preserve capital in the event of an unexpected turn in economic conditions or geopolitical events.
4. After having risen near a 14-year high, the dollar has stabilized and should remain range-bound.
The power of the dollar to disrupt markets was highlighted again recently when President Trump told an interviewer that it is “getting too strong.” While this may have been the case for investors for much of the past three years, we think recent trends point to the unsustainability of its big run-up and potential to hurt U.S. companies – at least for the near to intermediate term.
The president’s remark underscored the fact that what is best for the economy is a dollar that is in the proverbial Goldilocks range: not too strong and not too weak. The difficulty comes in determining what level is “just right.”
A strong dollar, as anyone reading this commentary likely knows, keeps inflation and interest rates in check, makes imports cheaper and boosts the buying power of Americans abroad. It also bolsters the dollar’s status as the de facto world reserve currency, which was in question before the greenback began shooting upward in 2014.
The flip side is that it harms U.S. companies that derive much of their sales from abroad, which includes a sizable percentage of the S&P 500. It also takes a chunk out of the returns from international investments denominated in dollars. While other factors also were involved, that has been all too evident in the subpar returns of international funds since the dollar’s bull run began.
A dollar index (DXY) measuring the greenback’s value relative to a basket of foreign currencies has fallen about 5 percent since early in the year, bringing it closer to the sweet spot for investors. The dollar remains overvalued in our view, with little likelihood of rising much until U.S. economic fundamentals strengthen. It could be driven higher and out of its current stable range, however, if any tariffs or protectionist policies are enacted by Congress and the Trump administration.
President Trump is right in thinking that U.S. companies could be crippled if the dollar were to continue the surge that saw it appreciate by 30 percent in 2½ years to its highest level since 2002 in January. Barring any global shocks, however, we see the upside from here as limited with inflation still modest and pro-growth policies far from taking effect.
5. The Fed’s ongoing rate hike plans are justifiable in our view – so long as the pace of economic growth picks up.
Slow and easy seems to be the motto of the Federal Reserve, and that is fine with us. Under the latest timetable drawn up by Fed officials in March, when they made just the third interest rate increase in 15 months after none since 2006, this will remain the slowest rate-hike cycle in modern history. Even a tortoise can admire a pace that deliberate.
We were always wary of the risks entailed in the Fed’s decision to buy trillions of dollars in bonds and keep rates artificially low for years to try to rescue and rejuvenate the economy after the Great Recession. Still-languid growth shows the strategy was better at rescue than rejuvenation.
A return to more normal rates and a slimmed-down Fed balance sheet would be welcome. But the Fed must tread carefully in tightening and becoming less accommodative with its policy in order to avoid causing new problems for the economy.
We were heartened to learn from the central bank’s minutes that officials felt “significant uncertainty about the effects of possible changes in fiscal and other government policies.” That is the primary theme to our own investment views so far in 2017. Such continued wariness by the Fed may keep it from ratcheting up rates one time too many for the economy this year.
Cautious or not, it is notable for investors that the Fed is removing the punch, safety net or foot from the accelerator, depending on your metaphor of choice. If there was any lingering doubt, Janet Yellen erased it this month when she confirmed that the era of extremely stimulative monetary policy is coming to an end now that the Fed’s mandate targets have been reached with 2 percent inflation and 4.5 percent unemployment. Officials also are considering reducing the Fed’s $4.5 trillion balance sheet as soon as this year by shedding bonds.
So far, so good for the pokey pace. Defying all expectations, the 10-year yield actually has slightly decreased since the rate-tightening cycle began on December 16th, 2015, when it stood at 2.30 percent.
The key to Fed policy will be economic fundamentals, primarily annual GDP growth, which has languished below 3 percent since 2005 and posted back-to-back years (2014-15) above 2 percent only once in the past decade. If growth climbs out of if its low range and back above 2 or 2.5 percent annually, the Fed’s yellow caution light can be safely switched to green.
If the Fed pushes ahead with its exit strategy too aggressively and raises into weakening economic data, we would turn bearish. Three more rate increases this year, as some Fed officials envision, still may be cause for concern. As with most everything else this quarter, it all depends on what policies actually emerge out of Washington, and when.
Market exuberance about pro-growth potential under President Trump has been premature amid questions about the details, timing and prospects of his economic policies.
The stock market faces the potential for more volatility in the months ahead as the new administration’s ambitious proposals face reality and political battles in Washington intensify. The mostly calm period for markets since the November election is likely not sustainable.
Clients should remain on their long-term asset allocation targets, particularly given the lack of clarity out of Washington.
International stocks’ stronger returns are encouraging after years of underperformance. European elections and President Trump’s still-forming trade policies pose risks but could also be positives depending on the outcomes.
Despite market skepticism, bonds delivered positive returns for the first quarter even as the Fed raised rates. We expect yields to remain stable until we see signs of meaningfully higher economic growth and/or inflation.
Stocks sailed into the Donald Trump presidency full of momentum from his November election triumph and never really turned back in a first quarter marked by unusual market tranquillity.
The iShares S&P 500 ETF returned 5.9 percent for the quarter even after stalling in March amid questions about the lack of progress on the new administration’s fiscal stimulus initiatives. The S&P 500 went 161 days without a daily drop of more than 1 percent, the longest such period since June 1985.
Optimism about the prospects for growth from Trump’s infrastructure, tax and pro-business policies propelled sharp increases for growth stocks, especially technology. The tech-heavy Nasdaq Composite index returned 10.4 percent, fueled by jumps of between 18 percent and 24 percent for Apple, Facebook, Netflix and Amazon. The iShares Russell 1000 Growth ETF lapped its value counterpart, 8.8 percent to 3.1 percent.
Small-cap stocks lagged large caps in the quarter, moving up only modestly after surging nearly 20 percent higher in the month following the election. Uncertainty surrounding the administration’s tax reform efforts put a damper on their rally. The iShares Russell 2000 ETF, an investable gauge for smaller-company stocks, posted a 2.2 percent return. Smaller growth stocks performed better. The iShares Russell 2000 Growth ETF advanced by 5.2 percent, while the corresponding small-cap value benchmark declined by 0.3 percent.
Technology led the top-performing S&P sectors with a 10.8 percent rise, followed by consumer discretionary (8.4 percent) and health care (8.3 percent). Energy was the biggest decliner, sinking 6.5 percent on lower crude oil prices caused by persistently high supply levels. Telecom was the only other loser, falling 5.0 percent.
International developed stocks turned the table on their U.S. counterparts to start the year after long trailing them, aided by improved global economic data and a perceived risk decline in Europe. Emerging market stocks performed even better, outpacing all other asset classes in the quarter. The iShares MSCI All-Country World ex-US ETF, measuring a broad range of international developed and emerging market companies, delivered an 8.3 percent return.
Non-U.S. developed-world stocks as benchmarked by the iShares MSCI EAFE ETF rose 7.9 percent. Measured in local currency, before converting to the declining U.S. dollar, the quarterly return was 4.9 percent. Performance was strong in both the Asia Pacific region and in Europe, where economic reports were more favorable and a breakup of the eurozone was viewed as less likely following the election defeat of a far-right candidate for Dutch prime minister.
The iShares MSCI Emerging Markets ETF, measured in dollars, surged 12.5 percent to exceed its full-year 2016 return of 10.9 percent. Rallies in China, India and Korea helped lift the investable index to a two-year high in March. Investors were attracted by lower valuations, the uptick in global economic forecasts and the 2 percent decline in the dollar, which helps developing economies.
U.S. real estate investment trusts lagged the overall stock market in the first quarter as investors took a more cautious approach toward the sector. Industry officials attributed the underperformance to both the ongoing interest rate hikes and the more uncertain outlook for the real estate market after the post-election surge of optimism in the fourth quarter.
The Vanguard REIT Index Fund returned 1.0 percent for the quarter, a significantly slowed pace after averaging double-digit annual returns for the prior five years. The recently created real estate sector within the Standard & Poor’s 500 was the fourth-lowest performer among the 11 stock sectors, returning 3.5 percent.
Foreign real estate stocks turned in a strong quarter, benefiting from investors’ bets on the Pacific region and emerging markets. The Vanguard Global ex-U.S. Real Estate Fund returned 6.8 percent – four times as much as it did for all of 2016.
Commodities retreated to start the year as oil and natural gas gave back some of the huge price gains they registered in 2016. The iPath Bloomberg Commodity Index Total Return ETN, tracking a basket of commodities in which energy comprises a disproportionate share, fell 2.9 percent.
The energy complex was pressured by rising U.S. crude oil inventories that offset the impact of an OPEC-led agreement to reduce global crude production. Oil was down nearly 6 percent in the quarter and natural gas fell 14 percent. Precious metals were among the positives as investors positioned against increasing inflation expectations and sought downside protection. Gold rose about 8 percent while palladium surged 17 percent.
Despite the down quarter commodities showed a return of 9.4 percent over the previous 12 months, a reflection of their strong 2016 after five consecutive years of declines.
Hedge funds as a category had a solid quarter, again outperforming bonds by most measures. Strategies focused on technology, health care and growth fared particularly well, lifting the overall category. Short-bias strategies, those betting on stocks to go down, were among the biggest decliners by category as U.S. stocks advanced steadily through the quarter.
The HFRX Equity Hedge Index, composed of investable hedge funds, posted a 2.7 percent return in the quarter. The HFRX Global Index, an investable benchmark that includes international funds, was up 1.7 percent.
Bond prices edged higher in the first quarter, a reflection of scaled-back expectations for higher inflation and government debt given the slow pace of the new administration’s economic agenda. Even in a quarter when the Federal Reserve raised the federal funds rate by 0.25 percent, the 10-year Treasury yield fell slightly to 2.39 percent from 2.45 percent at the start of the year. Bond prices rise as yields fall.
The Vanguard Total Bond Market ETF, a benchmark for higher-quality taxable bonds, gained 0.8 percent. It was negative for the year until the March 15th rate hike, when the Fed signaled it would maintain its cautious pace for future increases. That caused the 10-year Treasury yield to reverse course from a 2½-year high of 2.63 percent, with prices rising correspondingly in the last two weeks of the quarter. Internationally, Altair’s global fixed income investable benchmark – a 60/40 blend of the SPDR Barclays International Treasury Bond ETF and Vanguard Total Bond ETF – returned 1.8 percent for the quarter.
Municipal bonds outperformed taxable bonds, a partial reflection of low issuance in the tax-exempt market. Altair’s investable benchmark for the U.S. muni market – a blend of the Market Vectors’ short and intermediate ETFs – advanced 1.5 percent.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.